TIPS for Inflation Protection
Inflation was very low in 2014 and 2015, with annual rates of just 0.8% and 0.2%, respectively, as measured by changes in the consumer price index (CPI).1 The Federal Reserve’s decision to begin raising interest rates reflects a belief that inflation will return to its more normal “run rate” of about 2% annually.2
That rate is still relatively low, but even moderate inflation can have a negative impact on the purchasing power of investments. Consider that a hypothetical investment earning 5% annually would have a “real return” of only 3% during a period of 2% annual inflation. This rate of return would be further reduced by income taxes.
Rising with the CPI
One way to help protect the purchasing power of your investment dollars is by investing in Treasury Inflation-Protected Securities (TIPS). Along with the earnings potential associated with other Treasury bonds, TIPS are indexed for inflation. If the CPI rises, the principal value of TIPS increases. If the CPI falls, the principal value falls. TIPS are guaranteed by the federal government as to the timely payment of principal and interest.
TIPS pay a fixed rate of interest twice a year based on the current principal, so the amount of interest may rise and fall. If you hold the bond to maturity, you will receive the greater of the original or inflation-adjusted principal, which provides the benefit of keeping up with inflation while protecting against deflation. Considering that over the past 60 years, every year has seen at least some inflation, the principal of TIPS held to maturity is likely to increase — though, of course, there are no guarantees.3 Unless you own TIPS in a tax-deferred account, you must pay federal income tax each year on the interest income plus any increase in principal, even though you won’t receive the accrued principal until the bond matures.
TIPS are sold in $100 increments and are available in maturities of 5, 10, and 30 years. Keep in mind that, like all bonds, the return and the principal value of TIPS on the secondary market will vary with market conditions and are sensitive to movements in interest rates. When interest rates rise, the value of existing TIPS will typically fall on the secondary market. However, changing rates and secondary-market values should not affect the principal of TIPS held to maturity.